Eli5: why can’t we just “deflate” money, and why is it bad?
In: 620
I live in Switzerland where we had a deflation sitiation for a number of years. Virtually impossible to earn bank interest, in fact banks started charging negative interest on some bank accounts
First off, we *can* do that, and it goes by the name “quantitative tightening.”
Okay, sounds great, inflation problem solved, we can go about our business. Yay!
But it’s much worse than you think. What quantitative tightening does is it removes liquidity from the system, which means there’s less money for banks to borrow from the federal government, which leads to it being more difficult for businesses to start up or borrow money for capital improvements, which eventually leads to economic stagnation if you let it go on long enough.
Then, when the inflation problem has hit zero and tips into deflation territory, you start thinking, “Great! My money is worth more than it was yesterday!” and then you rationalize this as, “My money will be worth more tomorrow. I will not spend my money today. Or tomorrow, because it will be worth more the next day!” and so on and so on. This is obviously problematic for businesses, because people are now hoarding their money, so the businesses (which still have to pay rent and salaries) start losing money, so they start letting people go, and now you’ve got an unemployment problem on your hands. And then, as businesses shut down, new ones don’t open in their place because your quantitative tightening policies have made it so banks aren’t loaning money to anybody except for companies that already have so much money that they don’t need it. This exact scenario happened in 2008, although it started for reasons unrelated to quantitative tightening. However, when consumer spending goes down, the first places to go are local restaurants, and it spreads like a cancer from there.
Meanwhile, amidst all of this, because consumer spending has hit near-zero levels, the stock market tanks, taking everyone’s retirement portfolios along with it, so now if you were planning to retire next year, you’re working another ten years. You’d like to sell your house in order to move into a smaller place, but nobody can get home loans, so you’re stuck where you are. Maybe people take what they can get for their houses, which drives down home values, which drives down property taxes, which now is a big problem for communities’ abilities to pay their bills for things like fire and police departments, infrastructure maintenance and construction, school funding, et cetera.
And it’s all because people started the day by saying, “I’m not going to spend money today.”
Deflation is not seen as good for the economy because it discourages investing.
We like our economy to have a steady-but-manageable level of inflation over time because that means if you just sit on your money without doing anything with it, you will lose value over time. If you put $100,000 in a safe for 20 years, you will not be able to buy as much with it when you take it out of the safe. In order to “beat” inflation, you need to invest it somewhere it will produce returns greater than ~2% per year. Investing means companies are able to expand, which means they can provide salaries to more employees (more spending money in the general population) and produce more goods and services for people to buy, which makes the company more successful, which makes the investors more money to invest further.
You can see it’s cyclical, every step of the system needs to work properly to prop up every other step. The investor class needs to be investing, the general population needs to be buying, and the companies need to be paying employees well and producing product. If one of those three doesn’t behave “properly” then the other two will stop doing their part as well.
If currency is experiencing deflation, then that $100,000 from before will be worth *more* when you take it out of the safe, twenty years later. That means it is a safer bet to *not* invest in the long run, which causes breakdowns all along the cycle. Corporate stock value falls if people aren’t buying it, so they have to operate more efficiently, so unemployment rises, so people aren’t spending money on product, so the company does not look good to investors, and now we’re stuck in the negative version of the same loop.
Wages and prices would go down but your outstanding debt would not.
Millions of people would no longer be able to afford their mortgages on their lower wages.
It’s bad in the Big Picture, not on the small scale.
A little of deflation is good on the individual level, if I have $1000 that can buy 100 apples today, but 200 apples tomorrow, that’s great for me…. until….
But what happens when you a bit larger and multiply the effect up the economic food change.
Company X did the math and knows it needs to sell 100 widgets a day to cover it’s expenses, like loans, payroll, materials, etc. Suddenly the price for widgets at the store goes down (deflation) now it needs to sell 200 widgets to make the same profit. But deflation doesn’t mean people’s needs change, the demand is still only for 100 widgets. So the company is in trouble, it needs to cut down expenses to stay in business. That means not taking on debt (like loans to buy new factories, or expand it’s production) that means maybe laying off employees, and that means cutting back on things like employee travel, lunches, parties, etc.
So that means the construction company (who would have built the new factory), the travel agents, the caterers, the party planners, all don’t get that revenue and they start going out of business. Employees start getting laid off too, that’s obviously bad for the employees.
In short, the deflation triggers a decline in the economy that eventually hurts everyone.
It all comes down to supply vs. demand. At the start of deflation you have more supply than demand (the company can produce 200 widgets, but only 100 are needed by the market) so the reaction is supply needs to decrease (the company lays people off, factories close etc) until it meets up with demand again.
Typically that means theres a recession where money becomes more valuable. So that’s not a good thing. Otherwise we can remove money from circulation (both physical and digitial), but how many people are willing to just give up their money voluntarily?
A modern economy only works because people spend money. If people stop spending money, they stop buying goods and services, which means that businesses have to lay people off, which means there is less money to spend, which means fewer goods and services sold, etc.
If a currency deflates, then it gains value by doing nothing at all. As a result, you are incentivized to wait as long as possible to make a purchase – after all, why buy a TV today for $500 when you can buy it next month for $450 or the month after that for $400. The incentivization to delay puts us in that downward spiral in my first paragraph. Additionally, people don’t want to invest for the same reasons – why do a risky investment when your money gains value just sitting in a coffee can?
That spiral is the death knell for an economy and is **so bad** that pretty much every government targets _some_ inflation if for no reason other than as a hedge against deflation.
Latest Answers